Patent Protection, Market Uncertainty, and R&D Investment

The main reason governments grant patent protection is to spur innovation. Patents give inventors temporary monopoly rights that allow them to appropriate a greater share of the returns from their innovations and this augments private incentives to undertake research and development (R&D) investment. Consequently, patent protection should stimulate private R&D investment. However, the size of this stimulus is far from clear since it depends on how effective patents are as a mechanism for appropriating returns.Drawing on real options investment theory, this paper highlights one mechanism through which patents may improve appropriability and stimulate R&D investment – by reducing the effect of market uncertainty on the firm’s investment decision. Real options investment theory predicts that greater uncertainty about market revenues reduces current R&D investment by increasing the value of waiting. A patent may protect the firm from market uncertainties including, among other things, imitation by rivals. This protection reduces the patenting firm’s sensitivity to market uncertainty, decreases the value of waiting, and leads to greater current R&D investment. For firms exploiting this “real options mechanism” of patent protection, R&D investment will be less sensitive to market uncertainties, such as revenue volatility.Our regression analysis tests this hypothesis. Using a sample of 692 West German manufacturing firms, we find that revenue volatility significantly reduces R&D investment by non-patenting firms whereas firms with patent protection have no significant response. This suggests that patent protection, acting through the real options mechanism, diminishes the patenting firm’s sensitivity to market uncertainties and stimulates R&D investment.But how important is this mechanism? Schankerman (1998) suggests calculating the “equivalent subsidy rate” (ESR) to measure the importance of patent protection for capturing private returns. We calculate ESR as the incremental increase in R&D investment from adopting patent protection for an average, previously non-patenting, firm. We find that patent protection induces a 20% increase in R&D investment and this is a measure of the private return to patent protection for our sample. To our knowledge, this “real options mechanism” has not been examined in the patent literature but it may prove to be a fruitful approach to understanding the impact of the patent system on investment and innovation